Momentum indicators are widely used by commodity traders to measure when a market is overbought or oversold. They're often a critical component of trading arsenals for traders who live by the old adage, "Buy low, sell high."
Key Takeaways
- The Relative Strength Index (RSI) is a momentum indicator that measures the overbought or oversold levels of the market.
- A reading of 70 or higher typically indicates the market is overbought, while anything 30 and below means the market is oversold and might be due for a rally.
- An effective way to use the RSI is to follow the trend and enter the market during pullbacks, when there is a solid support or resistance level.
- You can adjust the parameters on the RSI to suit your trading style.
Relative Strength Index
The Relative Strength Index (RSI) is one of the more popular momentum indicators and it's probably among the easiest to use. It measures the overbought or oversold levels on a scale of 1 to 100. The common setting for the RSI is 14. This means it tracks the last 14 periods, whether those periods are days or 5-minute bars on a chart.
The main thing you want to watch out for are readings above 70 or below 30. When the RSI is above 70, it means the market is overbought and likely due for a correction. When the RSI is below 30, the market is getting oversold and might be due for a rally. Of course, these numbers should only be used as a gauge to help you in your buying and selling decisions, not as a trading system.
Trading With the RSI
Many books have been written on trading with momentum indicators and the RSI, and there are multiple theories on doing so. Some methods simply aren't effective, but many traders successfully use the RSI in their own unique ways.
One of the best ways to use the RSI is to follow the trend and enter the market on pullbacks within a trend. First, identify a trending market. If you find a market that has been trending higher, the RSI will probably be near an overbought level of 70. You would look for a buying opportunity when the market corrects when the RSI reaches an oversold level near 30.
This method is an easy way to identify buying opportunities in trending markets. The RSI will ideally prevent you from chasing a market that's in an overbought condition. Your risk is much lower if you buy a bullish market when it's not in an overbought state. This trading method also helps a trader exercise patience and discipline.
Note
Many novice traders can't stand to sit back and watch a market run higher. They inevitably chase the market and often enter at the high for the move.
A question many traders ask is whether they should simply buy when the RSI drops below 30 or sell when the RSI is above 70. The answer would be no. If you're buying on a correction within a trend and the RSI falls into a desirable range, look for an entry point. That entry point would often be an area of support for uptrends and resistance for downtrends. You could also look for technical reversals that suggest the market has made a sharp turn.
This gives you three good rules for entering a trade:
- Follow the trend
- Enter on pullback
- Enter at a solid support or resistance level
Adjust Parameters to Suit Your Style
Some markets will enter into very strong trends at times without much of a correction. The RSI can stay at overbought or oversold levels for prolonged periods of time.
Note
Don't blindly sell overbought markets. Too many traders have been burned making this mistake.
Most experienced traders will adjust the parameters on the RSI to meet their trading style. Some are short-term traders and they like a fast-moving RSI so they adjust the periods to a lower number like 4. You can also watch different levels for overbought and oversold.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented withoutconsideration of the investment objectives, risk tolerance or financial circ*mstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
FAQs
In conclusion, the Relative Strength Index (RSI) is a powerful tool in the trader's arsenal, offering a window into the market's soul. It provides traders with a numerical narrative of overbought and oversold conditions, potential trend reversals, and the strength of market movements.
How reliable is the RSI indicator? ›
Additionally, RSI can remain overbought or oversold for long periods of time. So even if a divergence suggests that a stock might move a certain direction, there's no guarantee. Reading RSI also requires subjectivity that benefits from hindsight.
What is the best indicator to use with RSI? ›
One technical indicator that can be used in conjunction with the RSI and helps confirm the validity of RSI indications is another widely-used momentum indicator, the moving average convergence divergence (MACD).
How to use the RSI indicator effectively? ›
The common levels to pay attention to when trading with the RSI are 70 and 30. An RSI of over 70 is considered overbought. When it is below 30 it is considered oversold. Trading based on RSI indicators is often the starting point when considering a trade, and many traders place alerts at the 70 and 30 marks.
Can you trade using only RSI? ›
However, trading using RSI signals only is not the best approach as it has been designed to be used as a filter and not the main instrument. A technical trading strategy will be more efficient when using a trend indicator or at least paying attention to the Price Action signals.
On what timeframe is RSI most accurate? ›
As mentioned before, the normal default settings for RSI is 14 on technical charts. But experts believe that the best timeframe for RSI actually lies between 2 to 6. Intermediate and expert day traders prefer the latter timeframe as they can decrease or increase the values according to their position.
Is RSI 100% accurate? ›
Results from the RSI may be misleading when markets are trending so it should only be used during a ranging market.
What is the success rate of RSI? ›
The Triple RSI Trading Strategy is a top performing method for traders looking to improve their trading success rates. By combining three different Relative Strength Index (RSI) indicators, you can potentially achieve a win rate of up to 90%.
Should you buy when RSI is high or low? ›
Investors using RSI generally stick to a couple of simple rules. First, low RSI levels, typically below 30 (red line), indicate oversold conditions—generating a potential buy signal. Conversely, high RSI levels, typically above 70 (green line), indicate overbought conditions—generating a potential sell signal.
What is the best timeframe for RSI divergence? ›
The one-hour chart or longer is the best timeframe for the RSI divergence indicator. Is RSI or MACD Better for Divergence? The MACD is better for showing trend reversals. The RSI is better for showing overbought/oversold areas.
Relative strength index (RSI)
Anything above 70 is considered overbought, and anything below 30 is considered oversold. This momentum strategy is based on the idea that retracements between these price levels will present clear trends.
What is the RSI 2 strategy? ›
What Is the 2-Period RSI Strategy? Larry Connors developed the 2-period RSI strategy, a fairly simple mean-reversion trading strategy designed to buy or sell securities after a corrective period. Traders should look for buying opportunities when 2-period RSI moves below 10, which is considered deeply oversold.
What is the RSI spy strategy? ›
Even better, we improve the strategy by adding one extra indicator. The trading strategy is really simple and reads like this in plain English: If RSI(2) is less than 15, then enter at the close. Exit on close if today's close is higher than yesterday's high.
Can RSI reach $100? ›
The RSI oscillates between zero and 100. Traditionally the RSI is considered overbought when above 70 and oversold when below 30. Signals can be generated by looking for divergences and failure swings. RSI can also be used to identify the general trend.
Should I sell if RSI is above 70? ›
Low RSI levels, below 30, generate buy signals and indicate an oversold or undervalued condition. High RSI levels, above 70, generate sell signals and suggest that a security is overbought or overvalued.
What is a good RSI level to buy? ›
The relative strength index (RSI) provides short-term buy and sell signals. Low RSI levels (below 30) generate buy signals. High RSI levels (above 70) generate sell signals.
